Debt can overwhelm a business for so many reasons. A business can just tumble out of control and crash and burn. When that happens, the owner has two main choices. First, you could negotiate a settlement with your creditors. It’s just a negotiation between the owners and the creditors, without court involvement. This is referred to as an “informal workout.” The second option is to file for Chapter 11 bankruptcy. This is usually referred to as a “bankruptcy reorganization“. As a general rule, a deal your creditors agree to outside court is the better outcome, but whether you can get one usually comes down to a few questions, and the first is about cash.
If you are cash poor, you need a fast, low-cost solution, and that points to a settlement. While settling the debts outside of court will be faster, and often times cheaper than filing Chapter 11, you also have to make sure that you have enough runway to work through the proposal and negotiations with your creditors. If you run out of cash before that happens, then you will have to file for bankruptcy protection and file the case in Court anyway. If, on the other hand, you can manage to eke out a few months to negotiate a settlement, then try for that first.
The second question is how many creditors you have. In an out-of-court restructuring, every creditor must sign the deal. If you have only a few creditors, they’re more likely to agree to the proposed deal. If you have lots of creditors, you’re more likely to find that at least one says no. That includes the bank, your vendors, your suppliers and everyone else you owe. The complexity of the debt structure influences the chance of success. If a business has a complicated structure such that it is unclear who holds which claims, or what claims are present (if any), it will be harder for all of the creditors to agree to a restructuring. Relationships matter too: if the business has a relationship with its major creditors, it is easier to negotiate a restructuring agreement. By this we mean that if the business and the major creditors have a shared understanding of what went wrong and how to fix it, then a successful restructuring agreement is more likely.
Real Advantages
If a settlement is within reach, there are real advantages to it. The first is that a settlement usually costs less than a Chapter 11 restructuring. It also leaves you more room to negotiate terms that actually fit your business. Even better, it takes less time to work out a settlement than a Chapter 11, on average six to nine months, versus nine to twelve. So there’s much less distraction. And because you don’t have to report what you’re paying as often, your financials stay more private, and you have less chance of rattling your employees and suppliers.
The second advantage is one of goodwill. If creditors have enough faith in your management team and your business to agree to work with you outside of court, they are essentially taking a bet that the problems you’re having are temporary. Otherwise, they’d have demanded all the protection of a court case.
The downside is everything a settlement does not give you. By not filing for bankruptcy, you can’t use the automatic stay to bring all collections activity to a halt. That means all of your debts remain, and can still be collected upon while you negotiate. (And yes, creditors are free to sue you while you negotiate). All of the creditors have to agree. If they don’t, the settlement doesn’t take place, and you’re back to square one. Your strategy for the settlement can be thwarted by a holdout.
That is where Chapter 11 earns its place. Immediately, upon filing, an automatic stay takes effect. All collection efforts, lawsuits, and actions must stop, allowing your business to focus on getting its operation running smoothly. The plan is vetted by the court. Your creditors will take the court’s involvement and review of your plan seriously, making you more credible after you emerge. It gives you the ability to reject executory contracts that you otherwise might not be able to get out of (some leases, licenses, franchise agreements, equipment rentals). This can be huge for many businesses, especially retailers.
Sometimes the decision is made for you. If your business can’t realistically continue, creditors will likely prefer to deal with you inside Chapter 11. It gives them court protections. In such a case, the best outcome may be to sell the company. You must understand that a buyer will much prefer to buy through Chapter 11, because it can take the business free of liens and claims against the assets.
None of that protection is free. The debtor has to pay both the court fees and the attorney’s fees (and probably fees for other professionals too). Bankruptcy protection means waiting around in a formal federal court process, so everything takes longer. Also, everything goes public: monthly reports on financial statements and budgets. Especially now that everything’s online, anyone who wants can find out. Finally, bankruptcy isn’t the same thing as negotiating with a creditor. It’s a legal process, not a business one, complete with formal rules and protocols.
Be Honest with Yourself
So be honest with yourself about three things. First, how much cash do you have in the bank? Second, how long do you think you can go before you are forced to negotiate with creditors and/or file a petition? And third, what is your current debt structure? In other words, do you have a manageable number of creditors? How simple is your debt structure? Do you have a bank that will work with you on a workout? Are you on good terms with your other major creditors, particularly your suppliers? If the answers are encouraging, your best approach would be a negotiated out-of-court workout. In many ways, you’ll have more options, be able to get it done sooner, and avoid the cost and publicity of Chapter 11. If the cash is about to run out, the lawsuits have already started, or there are simply too many creditors to bring everyone on board, it’s time to start considering Chapter 11.
Each case requires looking at the specific situation, company type, and available resources. Both routes lead to the same goal: Turning around the business to stable, profitable operations without risking insolvency. Either method can achieve this, but only if the owner acts decisively and strategically from the beginning. That’s a tall order, but an achievable one.
